Penni Johnston-gill - Apr 08, 2016

US equities; stalling at a tactical valuation ceiling. After rebounding nearly 15% from their lows, US equities have given back some gains. The probability of a pullback had risen given the spread between the S&P 500 forward PE ratio and the CBOE VIX

S&P 500, RBI, US Medical Equipment Makers by Martin Roberge

US equities; stalling at a tactical valuation ceiling. After rebounding nearly 15% from their lows, US equities have given back some gains. The probability of a pullback had risen given the spread between the S&P 500 forward PE ratio and the CBOE VIX reached the ceiling of “4” last Friday (Figure 1). Further weakness cannot be ruled out since the “buy” zone is located between “-5” and “-10”. That said, we do not want to play a correction as upside and downside risks, we believe, are evenly balanced. Otherwise, the tactical valuation indicator featured in Figure 1 implies that the S&P 500 will have a hard time pushing to new highs unless forward EPS estimates start rising anew. Hopefully, headwinds from past US$ strength should dissipate going forward (third panel) allowing EPS to re-accelerate gradually. Accordingly, market dips should be bought. Bonds provide a valuation support to stocks as lower US bond yields reflect a pull from lower yields across DMs rather than recession-like conditions. Our hunch remains that US equities could test new highs later this spring barring a major upturn in the US$. Keep an eye on US inflation data, EM currencies, EM bonds and EM credit/sovereign spreads.

EM monetary reflation has resumed. Before the March FOMC meeting on March 15, 14 EM central banks had hiked policy rates in 2016 while 6 cut them. Following the Fed meeting, the dovish bomb and the ensuing US$ depreciation, a net shift has occurred with 8 EM central banks cutting rates while 4 have tightened. True, this could be a trivial coincidence but the fact of the matter is that with the Fed now providing a currency backstop, EM central banks can pursue or resume monetary reflation without fearing a currency run and import-price inflation. As Figure 2 shows, the gap between average EM policy rates (~5%) and inflation (~4%) remains too wide and now that EM inflation is rolling over and likely headed to multi-year lows, EM central banks can now reflate more aggressively. This is exactly what the RBI in India did yesterday by cutting its repo rate by 25bps (to 6.50%) and more importantly, raising the reverse repo rate by 25bps (to 6%) to ensure that banks are awash in cash. The bottom panel of Figure 2 shows that Brazil, Russia, Indonesia and China are countries where central banks should be the most aggressive in cutting rates this year since real policy rates above 2% remain overly restrictive.

US Medical Equipment Makers (OW): In the April edition of the Quantitative Strategist, we lifted US MEMs back to an OW stance. Just like pharmas and biotechs, MEMs have benefited from favourable pricing conditions over the past few years. However, contrary to the former two groups which have become vulnerable to unfavourable price-fixing rulings by politicians, MEMs’ pricing power is likely to be more durable. Another positive, the trade-weighted US$ is now depreciating on a YoY basis. US MEMs should benefit from a lower dollar because pricing becomes more competitive relative to global MEMs. Indeed, foreign demand for US medical equipment should lead to stabilization in US MEMs’ trade balance (Figure 3, second panel). Last, the relative price underperformance of MEMs over the past two months has allowed for a much needed compression in valuation multiples. In fact, the group has become somewhat undervalued (Figure 3, third panel). Thus, sticky pricing power, a weaker US$ and improved valuations have prompted us to raise US MEMs back to an OW stance. Investors can have exposure to US MEMs by buying the IHI-US ETF. Otherwise, the top-5 rated MEM stocks by the Quest® triAngle are BCR-US, ISRG-US, SYK-US ZBH-US and BAX-US.

Still taking a knee – for now by Tony Dwyer

The market correction is basically progressing as we had hoped from when we turned neutral. The areas that saw the greatest advance from the Jan/Feb lows are the ones seeing the most profit taking. For example, the Philadelphia Oil Service Sector Index (OSX) was up 30% from the February low to March peak, and is now down 10% over the past two weeks. While our core fundamental thesis and history of such strong breadth thrusts keep us bullish over the intermediate-term, we believe a change in trend is not seen when the markets experience their first oversold bounce, but is more identifiable during the consolidation/correction period after the initial ramp off a historic low.

Tactical view continues to point to pullback. The sharp rally off the lows that brought the S&P 500 (SPX) within shouting distance of a new high was led by Commodities, Emerging Currencies, Corporate Credit, and the deep cyclicals. While there has been a rush to suggest a character change in the market due to the rally in these areas, there is little evidence of it at this point:

Oil overbought in downtrend. At its recent peak, West Texas Intermediate was up 60% from the 2/11/16 low of $26. It is pretty hard to imagine that percentage gain AND still be in a downtrend, but that is the case. In addition, it is also “hooking” lower from an intermediate-term overbought level using our trusty 14-week stochastic indicator.

High Yield ETF overbought in a downtrend. The iShares iBoxx High Yield ETF (HYG) has recovered with commodities, but has also reached into intermediate-term overbought in the context of a downtrend (Figure 2).

MSCI Emerging Currency Index in downtrend. Similar to the price of oil, this barometer of Emerging Currencies is also in a downtrend, although not as pronounced as the Oil (Figure 3).

Deep cyclical sectors in relative performance downtrend. An equally weighted index of the Energy, Materials and Industrial sectors remains in a well-defined downtrend relative to the SPX, and is on the verge of printing a new relative performance low (Figure 4).

Still taking a wait and see - but just for now. In order to identify a change in the trend, investors have to feel comfortable these troubled areas are not likely to see even worse levels than earlier this year, and that can only happen with a creation of a higher low on a pullback. All of these areas of the financial markets were due for a bounce in February given the extreme oversold nature and the history of post non-recession crashes – but we are now in the testing period to see if that was THE low. We would love to become more optimistic in commodities, corporate credit, emerging currencies, and the deep cyclical sectors, but we need more fundamental and tactical evidence. As the correction progresses, we believe investors should be more aggressive buyers as the market corrects below SPX 2,000 given (1) our positive core fundamental thesis, (2) the historically accommodative actions taken by the global central banks over recent months, and (3) improvement in the trend of domestic economic data. We are neutral in our sector view, because we are waiting for the above mentioned evidence.

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